Alternative to What? Making Money??

Over the years Wall Street has come out with new products to help investors “hedge” the risk of often wild and crazy markets. Liquid Alternatives, Unconstrained Bond Funds, Master Limited Partnerships and (the granddaddy of them all) Hedge Funds, are some of the fancy names thrown around to impress naïve investors.

These funds are often pitched as a cure-all for whatever ails you. This is not too different from tactics of the snake oil salesman, carnival barker or alchemist from previous times; i.e., people who made promises they could not keep, to an audience looking for answers in an uncertain world.

These funds promise, among other things, to act as “bond substitutes;” to “make money in all markets;” and to provide a “stabilizer” to portfolios during wild market swings. Like Communism, the idea sounds pretty good. Unfortunately, the reality of the outcome ruins the pleasing narrative.

The numbers don’t lie. During the last five years, an investment in a fund that used many of these alternative strategies would have been very disappointing and expensive.

A multi-alternative fund that used a basket of these strategies would have given you the same return as a boring old intermediate bond index. An investor would have the added bonus of paying about thirty times more in fees for this privilege. For example, you could buy the popular AGG Bond Index for .o7%, instead of the alternative product’s cost of 2%, which many of these portfolio strategies charge.

The story gets worse. When the market corrected in August, the alternative fund would have lost about five times as much as the bond index. The result of this alternative strategy is that you would have missed out on most of the enormous gains of the market the last 5 years, while earning a bond-like return, but without the downside market protection of owning a traditional bond index (in other words, the worst of all worlds).

As Simon Lack, author of The Hedge Fund Mirage, recently told the NY Times, “Hedge Funds have failed to beat a 60/40 stock/bond mix since 2002. They are on track to repeat this streak this year.”

Why do people continue to believe these stories and pay exorbitant fees in order to massively underperform the simplest of portfolios? The answers are: great marketing and rampant financial illiteracy.

In a great post by Dynamic Hedge, the author explains the real reason why financial companies come out with new products like these. Their purpose is not to help the consumer, but to make more money for the company and sales force.

Usually the old products are cheaper and more effective in finance.  Just think of the fancy mortgages of a few years back and car leases. In both cases, the consumer would have been better off purchasing the cheaper financial alternatives, like a plain vanilla 30-year mortgage or a no-frills car loan from the local credit union.

The same can be said for alternative investments. They are much more expensive and often much less effective than the old stand-bys like the S&P 500 Index, and Vanguard’s Total Bond Market Fund.

Recently, JP Morgan got themselves in heaps of trouble for “steering” clients into a hedge fund they conveniently own. It turned out by 2012, JPM’s private bank clients owned an astounding 72% of its fund, Highbridge Capital Management!

No wonder! If you could charge them a 2% fee and then charge 20% on all profits, it would make no economic sense for the firm not to put their client’s funds into Highbridge. Fortunately, we have the rule of law in this country and these transactions are now under intense scrutiny.

We can’t just blame individual investors for these illogical choices. Some noted fund companies are adding “alternatives” into their target date funds which populate many 401k plans.

For example, AllianceBernstein is putting 2% of its target date 2020 fund into a unconstrained bond fund and another 2% into “a fund that aims to make money whether markets rise or fall.”

Maybe it’s me but if you really thought a fund “could make money whether markets rise or fall,” why not put 100% of the money into an investment that promised this investing version of nirvana.

A 2% allocation will not have any real effect upon portfolio performance. This token contribution seems pretty silly. Of course, if your goal is to keep up with the “latest and greatest” to justify your high fees, using this fund makes much more sense.

There are a few real alternatives for investors who want to hedge the sometimes volatile world stock markets. The C.S.D. approach will work just fine.  A combination of cash instruments like money markets and CDs along with a high-quality, short-term bond fund and a similar quality intermediate fund will do the trick.

Using your bank and low-cost ETFs or index mutual funds will end up costing virtually nothing and provide an excellent defense when markets take their occasional turns for the worst.

While there is nothing sexy about this approach, it has worked over time, though nothing in investing is ever guaranteed. This inexpensive hedge has a high probability of filling an important defensive role in your portfolio.

The “alternative” is buying an expensive, hard to understand, and possibly illiquid (i.e., you can’t sell it when you need to) combination of investments that will make the investment management company, not the investor, a ton of money.

Make the smart choice and ignore the Wall Street sales machine that is looking to separate you from your hard earned cash. Stick with the old dependable products and save yourself a lot of stress and dashed dreams.

Who knows? Maybe the cost savings and added investment return of avoiding these “alternatives” will let you retire a few years early.